Are the Fed and the ECB falling behind the curve?

If you believe some of the U.S. Federal Reserve (Fed) governors' forecasts, the answer for the Fed's case is a resounding "yes."

Speaking at the Sixth Annual Rocky Mountain Economic Summit in Jackson Hole, Wyoming, last Friday these Fed officers confidently predicted that the U.S. economy would be growing at a rate of more than 3 percent over (an unspecified number of) next quarters. At the same time, they announced that an increase in interest rates was likely to begin in late 2015 or sometime in 2016.

Here is why these forecasts clearly imply that the Fed is already behind the curve.

With an estimate of U.S. economic growth potential somewhere in the range of 2 to 2.25 percent, an actual growth rate of more than 3 percent, sustained over several quarters, would create labor and product market pressures that would lead to accelerating inflation.

Obviously, if such a scenario were to pass, interest rates would begin rising much before the second half of 2015. And, as always in similar situations, the prospect of an open-ended credit tightening would create serious problems in asset markets, without any guarantees of promptly reestablishing market stability and inflation control. That is what is meant by the monetary policy falling behind the curve.

This also clarifies that the furious debate we are now witnessing about the policies conducted by the American and European monetary authorities must be based on thoughtful forecasts about the economic conditions likely to prevail over the next twelve months rather than on what we see at the moment.

That is tough. And to make things even more difficult, this particular forecasting exercise has to contend with additional uncertainties, which are technically called "lags in the effect of monetary policy." In other words, we don't know exactly how long it takes for a change in monetary policy to affect demand, output, employment and inflation. That, too, has to be estimated.

Depressive policy mix

Think, for example, of the fact that virtually zero interest rates in the United States since 2008 are still leaving the economy with an estimated output gap of more than 3 percent – a measure of output waste in an economy operating below its noninflationary growth potential. The euro area economy has a similar output gap, despite its record-low money market rates of 0.2 percent since September 2012.

This evidence contradicts the Nobel Prize winning economic research showing that it takes about four quarters for changes in monetary policy to affect output and prices.

Why that happened will probably be the topic for another Nobel laureate. Meanwhile, here are some of my guesses.

First, I believe that the effectiveness of U.S. and European monetary policies has been greatly impaired by a crisis-induced slowdown of bank lending. The transmission mechanism of the monetary policy got out of order because the weakened banking system was unable, or unwilling, to take the risks of extending credit to businesses and households.

Bank lending in the United States remains relatively weak despite increasing excess reserves (aka loanable funds). In the year to May, for example, banks' consumer lending rose only 5 percent. That is clearly at odds with an annual increase of 33 percent in excess reserves banks held at the Fed last month. U.S. nonbanks are much more active. Dispelling any doubts of the weak credit demand, their lending to consumers in the first five months of this year has been rising at annual rates of 7-9 percent.

Stop printing, fix the transmission

And the Fed keeps pouring in new money. In the first half of this year, its monetary base has been growing at an average monthly rate of $38.5 billion. At the end of June, the Fed's high-powered money stood 23.3 percent above its year-earlier level.

A 5 percent increase in the banks' consumer lending is very little to show for all that enormous money supply the Fed now does not know how to withdraw without creating major problems in liquidity-driven asset markets.

The upshot is that the impaired monetary transmission and the restrictive fiscal policy have created a policy mix offering very little support to the U.S. economy. Collapsing the budget deficit over the last six years from double digits to an expected 2.8 percent of gross domestic product (GDP) this year is a major effort of fiscal consolidation whose depressive impact has dampened the monetary stimulus.

The euro area is struggling with a similarly restrictive policy mix. Bank lending to the private sector in the first five months of this year has been falling at an annual rate of 2 percent. The latest monetary statistics for May show that lending to households fell 0.7 percent from the year before, after stagnating in the previous month. Mortgage financing also declined, and the volume of loans to non-financial businesses fell 2.5 percent.

Clearly, the euro area channels of financial intermediation are clogged up. Excess liquidity is fueling asset markets, but the real economy is not seeing much support from near-zero interest rates.

Despite calls for greater flexibility on the way to lower budget deficits, the monetary union's fiscal policy remains unduly restrictive in the context of weak cyclical conditions and high unemployment.

This means that we have a restrictive policy mix in 35 percent of the world economy (the U.S. plus the euro area), which is supposed to serve as the main driver of trade and investments on a global scale.

Investment thoughts

The Fed and the European Central Bank (ECB) have been unusually defensive about the warning that their delayed "normalization" of interest rates could lead to financial instability and rising inflation.

But they said nothing about their impaired policy transmission mechanism. If they don't fix that, there is no point in having zero interest rates because the money will just feed into bubbly asset markets instead of financing loans that would benefit output and employment.

Will they do it? I hope they will, but I am not holding my breath for it.

Ample liquidity will continue to drive the U.S. and euro area equity markets.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.